Few tax incentives are more coveted than tax credits. As dollar-for-dollar tax offsets, tax credits are almost as valuable as cash on hand. One such credit, found in § 41 of the Internal Revenue Code, allows certain business that invest in qualified research to claim a tax credit to offset some of their expenses. This is known as the Credit for Increasing Research Activities, commonly referred to as the R&D credit.
Because it is such a valuable tax incentive, businesses understandably want to do whatever they can to increase their chances of qualifying for the R&D credit. And yet, it can be extremely difficult to predict in advance whether a particular research activity will qualify. This uncertainty is even more acute in the case of internal use software (IUS). Research for the development of IUS is eligible for the tax credit only if, in addition to the standard test for qualified activities, it also passes an additional "high threshold of innovation" test.
As will be shown below, while it can be difficult to satisfy the "high threshold of innovation" test, it is not impossible. This article will outline how, despite the many hurdles imposed by the Internal Revenue Code and regulations, businesses can increase their chances of qualifying for the R&D credit.
This article includes the following sections:
- Overview of the history of the R&D credit, and requirements
- How the R&D credit applies to Internal Use Software (IUS)
- Tips to increase the chance of making a successful claim
This article concludes with a summary of how legal research tools can help by providing more certainty to taxpayers and tax professionals while saving time and increasing savings.
Overview of the R&D Credit
The R&D credit was originally introduced in 1981 as an incentive to businesses to spend more money on research and development. Initially a temporary measure, the credit was made permanent in 2015. This should provide some degree of comfort to businesses who may be more inclined to invest in research activities knowing that the tax credit will likely continue to be available in future tax years.
The manufacturing sector is by far the largest beneficiary of the R&D credit, accounting for 61% of the total research credits claimed, or almost $6.6 billion. However, the R&D credit is not specifically targeted at any one industry sector or any one type of research.
Under § 41, in order to qualify for the R&D credit, the taxpayer must have incurred expenses which meet each of the following requirements:
- They represent deductible research expenses under § 174
- The research must be undertaken for the purpose of –
- discovering information
- which is technological in nature
- the application of which is intended to be useful in the development of a new or improved business component and
- At least 80% of the research constitutes elements of a process of experimentation.
If even one of these requirements is not satisfied the taxpayer will not qualify for the credit.
Internal Use Software (IUS)
While software development research is clearly eligible for the R&D credit, IUS is an important exception to this rule. The Revenue Code stipulates in § 41(d)(2)(4)(E) that research with respect to computer software which is developed primarily for internal use by the taxpayer is excluded from qualifying for the credit.
Until recently, courts had little guidance for how to interpret this section. Thankfully, the Regulations, found at 26 CFR § 1.41-4(c)(6), provide helpful clarity on the question of when an IUS may qualify for the R&D credit.
With few exceptions, research with respect to IUS will qualify for the credit only if, in addition to the usual test for qualified research activities, the software satisfies an additional "high threshold of innovation" test.
The test involves three elements:
- The IUS must be innovative;
- The development of the IUS must involve significant economic risk; and
- The IUS must not be commercially available.
Additional guidance on each of these elements is found in the regulations.
In order to prove that the IUS is "innovative" the taxpayer must be able to show a potential for a measurable and objective improvement, such as a reduction in cost or improvement in speed or other measurable improvement. The improvement must be economically significant. Note that the software need only have the potential to result in such improvements, if successfully developed. The taxpayer is not required to prove that such results were actually achieved.
Key Tips for Claiming R&D Credits
The following are a few tips to improve your chances of successfully claiming the R&D credit.
Keep Detailed Records of Expenses
Tax credits are a matter of legislative grace, and the onus is on the taxpayer claiming the credit to prove its entitlement. IRS guidance provides that taxpayers "must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit....Failure to maintain records in accordance with these rules is a basis for disallowing the credit."
Track Employees' Time by Project
Most of the spending on qualified research activities is allocated to employee wages and salaries. In the event that an employee is engaged in both qualified research and non-qualified activities, only the portion of that employee's wages that are attributable to the qualified activities will be eligible for the credit. However, if 80% or more of the employee's time is spent on qualified activities, then 100% of the employee's wages will be considered qualified research expenses.
Consider Investing in Research Anyway
Businesses may be understandably cautious about allocating significant sums to experimental R&D with no certainty that they will receive a tax benefit in return. Given the highly uncertain nature of this tax position, it is in the taxpayer's interest to consider whether investing in R&D makes good business sense, even absent the tax credit.
Research often leads to innovation that benefits both the businesses behind it, as well as society as a whole. The R&D credit is available to help mitigate some of the risks, particularly when the research involves a significant economic risk. However, the potential tax credit should be just one of the many reasons for investing in research.
How Technology Can Help
A new generation of computational legal research tools are available to help tax professionals navigate the most uncertain tax positions. Blue J Legal's Tax Foresight is an advanced research platform that helps tax professionals assess the strength of their position by predicting the likely outcome of their situation if it went to court.
Tax Foresight offers two specialized modules on the R&D credit. The Research Credit Navigator guides the user through a series of questions that produces a determination on whether a taxpayer's activities fall within the definition of qualified research activities.
The Research Credit Case Finder allows users to search by factor within the entire universe of cases and decisions on the R&D credit, including industry sector, expert witnesses, and whether the research was successful.
 U.S. Department of the Treasury, "Research and Experimentation (R&E) Credit," (October 12, 2016). https://www.treasury.gov/resource-center/tax-policy/tax-analysis/Documents/RE-Credit.pdf
 IRS "Audit Techniques Guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) IRC § 41* Substantiation and Recordkeeping," (Last Reviewed or Updated January 29, 2019). https://www.irs.gov/businesses/audit-techniques-guide-credit-for-increasing-research-activities-ie-research-tax-credit-irc-ss-41-substantiation-and-recordkeeping.
 U.S. Department of the Treasury, "Research and Experimentation (R&E) Credit," (October 12, 2016). https://www.treasury.gov/resource-center/tax-policy/tax-analysis/Documents/RE-Credit.pdf.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.